JOHN HUSSMAN DEFENDS HIS RECESSION CALL

In his latest weekly letter John Hussman explains why his recession call has not been invalidated by recent economic data and why a 25% decline in the market would not be surprising here:

“On a related note, we’ve seen a few suggestions that because the latest Purchasing Managers Index came in above 54 (the January figure was 54.1) and the S&P 500 is now above where it was 6 months ago, any concern about a recession is now invalidated as two of the four components of our basic Recession Warning Composite (see Expecting A Recession ) are no longer active. Put simply, this is not how this particular “Aunt Minnie” works. At least one signal from the Recession Warning Composite has appeared either just before or during each of the past 8 recessions, without false signals (the PMI never hit that 54 level in 2010), but those signals are typically not “step” impulses that stay continuously active. Rather, the appearance of even one composite signal is, in and of itself, cause for some recession concern. But given the simplicity of the Recession Warning Composite, a much broader set of evidence is clearly preferable, much of which has been the subject of numerous recent weekly comments.

As it happens, I received identical criticism of my recession concerns in May 2008, when the S&P 500 briefly rose above its level of 6 months earlier, and credit spreads briefly retreated from their levels of 6 months earlier, leading to suggestions that even our own recession evidence had “turned.” At the time, the Fed was easing, Congress had passed an economic “stimulus” in the form of tax rebates, economic reports were coming in tepid but ahead of expectations, and any concern about recession was viewed with disdain. The S&P 500 had advanced about 12% over a period of about 10 weeks, and was only about 8% below its 2007 peak, having recovered much of what was (in hindsight) the initial bear market selloff. This was the most recent example of the “exhaustion syndrome” that emerged again last week (see Warning: Goat Rodeo ).

At the highs of that May 2008 advance, I observed “The reality is that as recessions develop (and I continue to believe the U.S. faces a much more significant downturn than we’ve observed to date), the data can take months to accumulate to a compelling verdict, and in the meantime, speculative pressures can remain alive” (see Poor Fundamentals with Borderline Market Action ). A few weeks later, the surreal calm in the face of seemingly obvious risks prompted the title of my June 2, 2008 weekly comment – Wall Street Decides to Close its Ears and Hum , where I noted “investors appear to be viewing the recent period of weak but not terrible economic news as a signal that the worst is behind us and that clear conditions are ahead.” Memorably, that was not the case.

Though I don’t expect a 2008-type collapse here, I would view a 25% market decline as only run-of-the-mill. I don’t view the probability of recession as 100%, but the leading evidence continues to indicate recession as the most likely probability. While we track a very broad set of data, a crude but useful rule of thumb is that the combination of a) an upturn in the OECD leading indicators (U.S. and total world), coupled with b) a turn to positive growth in the ECRI weekly leading index, has generally been a good sign that recession risk is receding. Those shifts can occur fairly quickly, but we don’t observe them at present.

We aren’t oblivious to the comfortable reports from indicators that typically lag the economy, but we also see disturbing recession risks in indicators that typically lead the economy. The problem is that even though investors know that lagging data lags, it deals with actual recent outcomes that can be “seen and touched.” In contrast, even though investors know that leading data leads, it deals withunobserved future prospects that have not yet been realized. It’s natural to focus attention of what can be seen and touched, even if it’s not indicative of the future.”